Fed's Tarullo: Shadow Banking Creates Risks

A top Federal Reserve official on Tuesday renewed a call for checks on the so-called shadow banking system, which operates outside normal, regulated banking channels, to prevent a repeat of the panic that provoked the 2007-09 financial crisis.

Fed Governor Daniel Tarullo did not comment on the outlook for the economy or monetary policy in the speech, which covered similar ground to remarks he made last month.

Banks that rely on deposits from investors are backed by deposit insurance and are closely watched by regulators. However, many financial firms lend money through a range of other channels, in what has become known as the shadow banking system, and escape such scrutiny.

Tarullo said that despite financial reforms, the shadow banking system has the potential to destabilize the broader financial system.

"The shadow banking system ... has only been obliquely addressed, despite the fact that the most acute phase of the crisis was precipitated by a run on that system," Tarullo told a conference organized by the San Francisco Fed.

In the wake of the crisis and the painful recession that followed, the Fed has taken on a bigger role in financial oversight and Tarullo has been a leading voice on the topic.

He said regulators and scholars need to do more work on financial institutions that behave like banks but are outside the scope of bank regulators.

"We should act now to address some obvious sources of vulnerability in the financial system," he said.

Tarullo repeated his support for proposals to bolster the soundness of money market mutual funds. He endorsed a suggestion that supervisors set limits on banks' reliance on funding provided by money market funds.

The Fed official called for more public information about repurchase, or repo, markets, in which firms exchange securities with a promise to buy them back after a specified period.

Tarullo said the point of reforms would be to make clear there are risks associated with the shadow banking system, and to prevent panics.

"Reforms are necessary so people can understand that you don't get risk-free assets that are paying more than genuinely risk-free assets," he said.